Long-term capital gains and qualified dividends are taxed at lower rates ranging from 0% to 20%.

So it should be really simple to figure out your marginal tax rate. Right? Wrong. Here’s why. You’re probably affected by some unfavorable federal phase-out rules and limitations, plus you may owe federal employment taxes, the new 3.8% Medicare surtax on investment income, and state income tax. All these things can affect your marginal rate, and they can only make it higher. Let’s start with an example to illustrate the point.

Example 1: You are a married joint-filer. You and your spouse are both employed and earn about the same amount. For 2014, your adjusted gross income (AGI) will be $145,000 unless something changes. AGI is the number at the bottom of the first page of your Form 1040. It includes all taxable income items and is reduced by certain write-offs such as deductible retirement account contributions, alimony paid to an ex-spouse, and moving expenses.

Say your 2014 taxable income will be $115,000 unless something changes. Taxable income is AGI reduced by personal and dependent exemption deductions ($3,950 each for 2014) and either the standard deduction amount or your total itemized deductions if they exceed the standard deduction.

You are now considering taking a new job that would increase your salary by a cool $30,000. According to the federal income tax rate schedule, that extra $30,000 would be taxed at “only” 25%. So you quickly figure out that you would pocket an extra $22,500 by taking the new job. [(100% – 25%) × $30,000 = $22,500]. Not so fast! Let’s say you have two under-age-17 children and that you pay $2,500 in annual interest on outstanding college loans. What is the real marginal tax rate on the extra $30,000 that you would earn from taking the new job? Here is the answer:

Effect of partly lost $2,500 college loan interest deduction due to phase-out rule: + 1.04%

Actual marginal federal rate (1+2+3+4): 38.69%

While you might think your federal marginal tax rate is “only” 25%, it’s actually 38.69% after taking Social Security and Medicare employment taxes and unfavorable federal phase-out rules into account. That’s 54.8% higher than the rate advertised by the government [(38.69/25.00) – 1.00 = .5476]. So your additional take-home pay from the new job would be only $18,400 instead of the expected $30,000. If you owe state income tax, your after-tax take will be even less. Yikes!

Next, let’s take a look at what can happen to a higher-income married couple.

Example 2: You are a married joint-filer. Your 2014 AGI will be $350,000 and your taxable income will be $280,000 unless something changes. Almost all your income is from your high-salaried job. You are considering taking on a crash-and-burn project that would pay you an extra $75,000 bonus this year. According to the tax rate table, the extra $75,000 would be taxed at a federal rate of “only” 33%. Assume you would also pay a state income tax rate of 7%. So you would pocket an extra $45,000 if you take on the project [(100% – 33% – 7%) × $75,000 = $45,000]. Right? Sorry, but not quite. Assume you have two dependent children and that you itemize deductions. What is the real marginal tax rate on the extra $75,000? Read on.

While you might think your combined federal and state marginal tax rate is 40% (33% + 7%), it’s actually a little over 45%. When the tax collectors would take close to half your bonus, you start to wonder whether it’s worth the extra effort and stress.

Why middle-income folks are more likely to see big differences between advertised and actual marginal rates

As the preceding examples illustrate, the sad truth is that middle income folks (like in the first example) are more likely to find unexpectedly big differences between their advertised marginal tax rates and their actual marginal rates than higher-income folks (like in the second example). That’s because middle-income taxpayers get clobbered by the deadly combination of unanticipated Social Security and Medicare taxes and tax break phase-out rules that amount to stealth rate tax increases.

High-income folks are above the Social Security tax ceiling, and most of their tax breaks are fully or partially phased out to start with. So collecting extra income doesn’t result in unanticipated additional Social Security tax on wages or the unexpected loss of tax breaks. However, higher-income folks are more exposed to the new 3.8% Medicare surtax on investment income and the new 0.9% Medicare surtax on wages and self-employment income. Still and all, high earners are less likely than middle-income folks to be shocked by big differences between advertised and actual marginal tax rates. If that strikes you as less-than-fair, I agree.

The last word

Whether your real marginal tax rate is higher than you thought or not, please keep reading this column for ways to lower your tax bills. It’s what we do!

Mortgage Rates

Powered by

This advertisement is provided by Bankrate, which compiles rate data from more than 4,800 financial institutions. Bankrate is paid by financial institutions whenever users click on display advertisements or on rate table listings enhanced with features like logos, navigation links, and toll free numbers. Dow Jones receives a share of these revenues when users click on a paid placement.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.